Financial Planning 101: the Secrets of Measuring Risk
Between catastrophes, fake news and fear-mongering everywhere, it’s hard to know what we should worry about these days. Tornadoes and floods? Artificial Intelligence taking over the world? Iowa Hawkeyes winning the big game?
Puns and jokes aside, worry (and its companion, risk) is the subject of this month’s installment of our Financial Planning 101 series. So far, we have addressed the right way to define your financial goals and looked at the value of financial planning. Money and risk go together, so addressing common mistakes in how people think about risk is a logical next step.
If you’ve ever met with an investment advisor, read an article about portfolio performance, or held your breath watching the stock market take a nose dive, you have heard about and experienced financial risk. However, not everything you know about risk is accurate or helpful.
Ubiquitous online risk assessment questionnaires may have you convinced that risk can be boiled down to a simple measurement. Answer 10-20 questions, and out comes a neat set of portfolio recommendations that alleviate your worries, match your financial realities and fit your dreams. Right?
Actually, that’s not the whole story. Risk isn’t any one number. It’s multi-dimensional, fluid and messy – just like real people. When I meet with clients, I encourage them to break complex ideas into small bite-sized pieces that they can easily understand and work with. The concept of risk is a good one to practice on. So, let’s look at the components that make up the bigger concept of financial risk.
Risk Perception
When people think about risk, they most often think about their risk perception. In other words, how do they feel about taking a certain risk? How comfortable are they with this portfolio allocation? How well do they sleep at night after making an investment decision? As any other feeling, it’s true and quite real to the person experiencing it. It’s also an imperfect measure of reality.
Let’s use an example to make the point. Suppose your aunt Suzie has a friend who is a wiz when it comes to computer technologies. Let’s call him Gus. Gus has convinced Aunt Suzie that cryptocurrency is a fantastic way for her to double her retirement savings in a year. Gus thinks that InsaneCoin is about to take off (we are picking on InsaneCoin just because it fits our example here, although it is a real thing).
Nothing inspires confidence like having “insane” in your investment’s name, but Aunt Suzie is adamant that this is the right choice for her. She has handed her life savings over to Gus so that he can buy her some InsaneCoin at a convention he is going to next week. She feels great about it. In fact, she sleeps like a baby, dreaming of the luxury cruise she will take when her investment makes it big.
Does Aunt Suzie’s comfort level have anything to do with the reality of her situation? Hardly. There is plenty of bad financial advice out there, and many people follow it without losing sleep. While InsaneCoin is an intentionally silly example, it works well to explain that risk perception is highly subjective. In order to use risk perception as part of your risk equation, you must add other ways to measure and think about risk.
Risk Tolerance
Risk tolerance is a measure of your willingness to take a risk. If Aunt Suzie from our example above understood the risks associated with putting her life savings into InsaneCoin and still chose to go ahead with that venture, we would say that she has a high risk tolerance. She would be willing to accept a significant amount of risk in exchange for the opportunity to make more money.
On the other hand, her sister Nelly is distrustful and suspicious of anything that involves letting money out of her sight. She keeps all her life savings under her mattress and refuses to put any money into a savings account, let alone invest in stocks and bonds. Aunt Nelly has a low risk tolerance when it comes to her finances.
Risk tolerance is similar to risk perception in that they are subjective. Both should be taken into consideration, but neither should be allowed to drive your money decisions.
Risk Demand
Risk demand is the amount of risk that’s needed to meet the requirements of a client's financial plan or financial goals. Risk demand is not defined by how you feel, but rather by the underlying mathematics and assumptions of your financial circumstances.
Let’s look at a married couple, Caroline and Jake, to illustrate this point. Caroline and Jake are in their 50’s. They would like to retire in ten years, sell their home, buy a yacht and sail around the world. Based on their savings and current assets levels, as well as our guess about what the stock market might do over the next ten years, they may require a 9% rate of return to meet goal. That 9% return will come from investments with a certain level of risk, which in this case is “demanded” by the combination of their goals, timeframes and financial resources.
Of course, the measure of risk demand is not the only “right” risk criteria. Just because your goals demand certain risk exposure doesn’t make that exposure a smart choice for you. Which brings us to the next component of risk: capacity.
Risk Capacity
Risk capacity is an objective view of risk. It’s driven by mathematical calculations that measure your ability to absorb financial consequences of taking a risk.
Let’s use an example of James, an aging bachelor who expresses his willingness to accept relatively riskier investments in exchange for being able to have a more luxurious lifestyle in retirement. He may have high risk tolerance (i.e. willingness to take a gamble) and high risk demand (i.e. math may require him to opt for higher-risk and higher-return investments to meet his lifestyle goal). However, James is only 18 months away from his target retirement date. If the market were to tank during those 18 months, his plan would have to be scrapped because his exposure to the market valuations would sink the value of his portfolio. Therefore, James has low risk capacity.
What does this mean for you?
There are a few things I want you to take away from this article.
First off, remember that humans are notoriously bad at being able to accurately self-report their risk tolerance. Because of various cognitive biases, people’s imagined response to a future event is often dramatically different from their real flesh-and-blood response when bad things actually happen. We have all seen examples of friends and family who are “theoretically” comfortable with a 33% market decline while sitting in an advisor’s office sipping coffee, but who lose their minds when the stock market comes crashing down.
The second point is that you should take the results of any risk measurement questionnaire with a grain of salt. As we illustrated above, risk is a complex and multifaceted subject. Many questionnaires set out to combine various risk factors and distill them down to a single number, which is a flawed approach in the best of times. In fact, a 2012 study has found that many risk measurement products have failed in being able to predict future responses and behavior under stress and pressure.
The final point is that applying the concept of risk appropriately requires you to look at all aspects of your situation and rely on professional help. No automated allocation will ever give you the full picture of proper fit. Some are better than others, but nothing will replace human judgment and support, especially when markets fluctuate in uncomfortable directions. Work with a fiduciary advisor who is required to understand the entirety of your financial and life situation, as that background is critical for proper risk assessment.